Tuesday, March 24, 2009

Geithner's First Plan


Well, the plan is out, and it looks sort-of like what I proposed (see just below).

Wall street cheered it. Someone once said (me?) that the fastest way to 'solve' the current financial problem was for the FED to start writing credit default swaps. In a (limited) sense, that is what the plan does, because the FDIC is providing 'guarantees' on debt, for a "fee", that will be used to purchase risky assets.

It's getting a nasty reception, from sensible people.

It does seem that the financing of the plan is getting the most fire, because it interferes with the pricing of assets (Krugman, Self-evident).

Leverage does not change the expected value of an asset. However, the presence of non-recourse loans does change the ROI, and that will cause people to bid up.

How much?

Well on my figures, it's not nearly as much as Paul's worried about. With an 80% standard deviation in the price of the 'toxic pool' of assets, I come up with a maximum 'subsidy' of about 11% change in the bid, the fair-value price, which occurs at the maximum leverage they propose (1:6).

This will not break the bank.

The quibble could be handled by an upfront FDIC financing 'fee', which could be set so as to price-out the value of non-recourse financing (at 11% in our maximum example below). It would raise the minimum private investment from circa 17% to circa 26%, as well., although fees are technically not 'equity'.

What is scary is that, the public takes circa 8.6 times the dollar amount of downside risk as does private part, at the maximum leverage. With an FDIC financing fee, as I suggest, that reduces to about 4.8x, which is still sizable. The public has far bigger shoulders, here.

Put another way, an 80% standard deviation for 'toxic assets' is way out of whack with a leverage ratio of 1:6 ... so is 50%, 40%, or maybe even 30%. [I suppose this is why the distressed asset guys so seldom use leverage, let alone quite so much.]

Basically, one would hope that they could do with a lot less leverage, that is, with a greater public-private partnership.


So, the focus is on the FDIC, how much insurance 'fee' they are going to charge and how they will determine how much leverage to use. Both are linked to their estimates of credit risk, primarily.

Also, the recalcitrant bad-loan holders will need to be forced to disgorge, competitively or by the regulator's stress-test.

Last, no one really knows how the RMBS housing markets will behave, as the efforts to stem foreclosures kick in.

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